Spot vs. Futures: Understanding The Impact Of Contango

Published on by on September 15, 2011 | Updated July 18, 2012

As interest in commodities as an investable asset has increased in recent years, more and more investors have sought to educate themselves on the various ways to establish exposure to natural resources and the factors that impact prices of these investment vehicles. Many have embraced ETFs and ETNs as efficient options, gravitating towards low cost vehicles that offer low maintenance strategies. And while a prolonged rally in commodity markets has delighted many investors, some have expressed frustration over gaps between exchange-traded commodity products and hypothetical spot returns.

This confusion arises from a lack of education and diligence on the part of investors who assume that commodity funds will deliver returns that correspond to spot prices. While some precious metals funds seek to deliver returns that correspond to spot, achieving this type of exposure is not possible in many markets–the physical properties of resources such as oil, corn, and natural gas make physical replication impossible.

So many commodity products invest in futures contracts linked to the actual commodity, allowing for exposure to resources without taking physical possession. What some have failed to grasp is that there are nuances related to futures-based investment strategies that can have a material impact on bottom line returns.

Contango has become a major value-killer when it comes to these products, deterring numerous investors. Contango is simply the process by which futures expiring further into the future are more expensive than the spot contract. Why is this an issue? ETPs that invest in futures have an automated roll process to avoid delivery on the contracts, so when a contract is about to reach expiration, the fund automatically sells out of the front month and buys in to a future month. While this is a major advantage to traditional futures trading, allowing for investors to hold commodity exposure without active monitoring, it can create some issues.

When futures are contangoed, this automated roll process will sell low and buy high, erasing gains for its investors and over the long run, it can have a major impact on a portfolio. This process also works in reverse, called backwardation, whereby ETPs sell high and buy low, actually creating more value for investors. Below, we demonstrate how contango works in practice:

Example: Contango In DBC

The DB Commodity Index Tracking Fund (DBC) is a popular commodity product that seeks to invest in 14 of the most heavily-traded futures contracts in the world. Underlying contracts include anything from natural gas to sugar or gold. With a base of 14 different futures contracts, DBC has the potential to exhibit steep contango.

To illustrate how contango can impact returns to a hypothetical broad commodity fund, we’ll walk through the trades a fund might make over the course of several months in order to meet its investment objective. To simplify things, we will focus on just the natural gas futures that DBC trades. Let’s assume that out broad commodity fund has $100 million in assets on October 1 to dedicate towards natural gas futures, which it invests in near month NYMEX futures contracts (i.e., contracts for November delivery). We’ll assume the fund rolls holdings on the 15th of every month, selling near month contracts and buying the second month contracts.

On October 1, spot natural gas is trading at $4.00/million BTU. We’ll assume the contract for February delivery is trading at $4.10, reflecting both costs of storing the underlying until that point and market expectations over future price movements. NYMEX natural gas contracts represent 10,000 mmBtu, so the fund in question would buy 2,439 contracts at $41,000 each.

January 1
Contract $/mmBtu # Contracts Value
Spot $4.00
BUY February Contracts $4.10 2,439 $100 million

Fast forward to January 15, when the fund begins to roll its holdings. Spot natural gas is still trading at $4.00, but the price of February futures has dropped to $4.05. The fund sells its contracts, generating proceeds of $98,780,488. It uses those proceeds to invest in March contracts, which are trading at $4.10. The fund’s exposure to natural gas contracts is now represented by 2,409 March contracts.

January 15
Contract $/mmBtu # Contracts Value
Spot $4.00
SELL February Contracts $4.05 2,439 $98.8 million
BUY March Contracts $4.10 2,409 $98.8 million

Spot natural gas prices have held steady at $4.00/mmBtu, but the fund has already lost 1.2% of its value through the “roll” process.

We’ll jump forward to mid-February, the point at which our hypothetical fund would sell its March contracts and roll into April futures. Spot gas prices have added more than 1% over the last month, climbing to $4.05. With expiration nearing, March contracts are still trading at $4.10 and April futures are slightly more expensive at $4.15. In order to maintain exposure, our fund sells March contracts for no gain and rolls into April futures:

February 15
Contract $/mmBtu # Contracts Value
Spot $4.05
SELL March Contracts $4.10 2,409 $98.8 million
BUY April Contracts $4.15 2,380 $98.8 million

The value of the fund remains the same over this month, though natural gas prices appreciated. Since the beginning of the year, spot natural gas prices are now up about 1.3% while our fund is down 1.2%.

We’ll carry the example forward for one more month to complete the illustration. Come the Ides of March, spot natural gas prices have dropped back down to $4.00. April futures are now trading at $4.05 and May contracts are priced at $4.10. As the fund rolls, the number of contracts held continues to decline–a nuance of futures investing in contangoed markets:

March 15
Contract $/mmBtu # Contracts Value
Spot $4.00
SELL April Contracts $4.05 2,380 $96.4 million
BUY May Contracts $4.10 2,351 $96.4 million

After less than three months, natural gas prices are at the beginning-of-year levels. But our natural gas futures investment vehicle has lost about 3.6% of its value by rolling from cheap contracts to more expensive contracts on a regular basis. Carrying this process out on a recurring basis can result in investors incurring a significant “roll yield” in order to maintain their exposure to commodity prices.

Lesson To Learn

Many investors focusing on establishing exposure to commodities concentrate on the impact that changes in supply and demand will have on spot natural resource prices. While these considerations are obviously important, it’s critical to also take into account the impact that the slope of the futures curve can have on returns. As the example above highlighted, contangoed markets can create strong headwinds for many commodity funds and commodity ETFs, even when the degree of contango is moderate and the holding period is relatively brief.

Investors should note that the presence of contango doesn’t necessarily mean that a fund will lose value over time. There are countless examples of funds exhibiting high contango but still posting strong results; the contango simply eats into a portion of those gains. Investors may also consider contangoed products for short exposure, allowing them to potentially profit from the process.

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